Help the Borrower

The $700 billion bailout package and the other financial bailouts will not work too well. Most of the bailout money goes to huge investment banks and others that are not truly banks but gambling corporations. They do not do ordinary deposits and loans. Furthermore, we should not concentrate on lenders but borrowers. Borrowers are the ones that are truly hurting.

The banking system as a whole has been completely corrupted by what some call the shadow banking system. The shadow banking system included investment banks, such as Lehman Brothers, Bear Stearns and Merril Lynch, that are caput. Other high flying investment banks, such as Goldman Sachs and Morgan Stanley, are on their way to extinction. Bank of America picked up one of these toxic shadow bankers, Merrill Lynch, and now is suffering as a result.

What is the shadow banking system? This is not real banking. It consists of securities dealers, hedge funds, and other non-bank financial institutions that are not subject to bank regulations. These shadow banks deal with securities. They make them so complicated that nobody - including those working with the securities - understands them. They also deal in what's called "credit-default swaps." Some economists believe that dealing in credit-default swaps is an extremely important factor in bringing about our current recession.

What is a credit-default swap? Let's say you buy a security, such as a municipal bond, corporate bond or a mortgage security, but you are worried about a default of the security. So you get a credit-default swap, an insurance-type contract against default. You make periodic payments to protect yourself against a huge loss.

Credit-default swaps of the shadow banking system have ruined not just the American economy but the entire global economy:

One key component of the shadow banking system are credit-default swaps..... While much attention has gone to subprime mortgages as causes of the financial crisis, the 60 trillion in swaps in mid-2008 is what really got the financial crisis going. The high rate of foreclosures alerted investors that something was not right, and hence a growing demand to cash in the swaps. The banking and financial system did not have those 60 trillion. This is more than global GDP.

The $60 trillion in swaps was more than the total GDP of the entire globe! Crazy, no?

What went wrong? Swaps are a form of insurance. By calling them financial instruments the shadow bankers avoided all banking regulations:

..... it is now clear that credit-default swaps are a type of insurance, but rather than selling them as such they were sold as derivatives. Why? Because if they were sold as insurance the law requires they be backed by capital reserves and be subject to considerable regulation. Making them into derivatives was a de facto deregulation and eliminated the capital reserves requirement.

What's the solution to this roundabout deregulation? Get rid of the shadow banking system. Make sure the banking system consists of normal banks that accept deposits and make loans. No hanky-panky. This will help the borrower.

Another way to help the borrower is with what's called "cram down." At present when an individual files for bankruptcy his debts may be reduced - but not for real estate. By instituting cram down, the debt may be reduced to the current value of the home. If you borrowed $500,000 and the value of your home decreased to $300,000, your mortgage would be adjusted to payments required for a $300,000 mortgage.

This is reasonable. This will bring loans in line with actual values. It's infinitely better than foreclosure.

Let's get our thinking away from ways to help the lender. It's more important to put the ordinary individual on his or her feet. To do this we must reform the banking system so ALL financial institutions are regulated, and help the borrower by means of cram down and other mechanisms.

Your entire article highlights all the reasons the repeal of the Glass-Steagal Act with the Gramm-Leach-Bliley Act was the lynch pin to this whole undoing of our economy.

Had the Republican Congress and President Clinton not passed and signed the GLB Act, the shadow banking system could never have grown to the “too big to fail” proportions that it did, and risk of financial capital would have been vastly better securitized, since credit default swaps were inherently an invention of institutions with cross bred lines of business, allowing them to leverage beyond all reason and measure.

Of course, releasing a lynch pin does not in and of itself necessitate the separation and collapse of the parts joined by it. Other weighty practices to follow did that.

There is no choice going forward now but to reinstate the protections of the Glass Steagal Act. The good news is, there won’t be much competitive advantage lost since all other modern nations are obligated to instate some form of Glass Steagal Act as well, in order to move forward with hope of reconciliation of this global financial debacle which started in the U.S.

Paul excellent article. The cram down concept should work for those in trouble on their mortgage since the value of the mortgage has been written down by the mark to market accounting practices in place since the Enron scandal. It is that easy isn’t it?

By instituting cram down, the debt may be reduced to the current value of the home. If you borrowed $500,000 and the value of your home decreased to $300,000, your mortgage would be adjusted to payments required for a $300,000 mortgage.

Thanks! I was looking for a term to describe that very same thing a while ago. Cram Down. Excellent and hits a nail on the head as a solution to one problem.

Craig, I think a rewrite of Glass-Steagal is required, updated to include the many new financial lines of businesses like hedge funds and credit default swaps and which financial institutions may engage in same and which may not.

Additionally, the whole arena of mergers and acquisitions, which the GLB Act attempted to accommodate needs to be updated and addressed for modern times, to include separation of lines of business amongst international and foreign holding financial institutions operating in the U.S.

Tom, no way. The bad assets on the books are in the trillions. $700 billion won’t even come close.

That is why we it is necessary, though horrible, that the government buy those bad assets at current market value determined by sampling, regardless of the write down for the financial institutions whether it be 40% or 70%. The financial institutions receive current market value cash for those assets, clean their balance sheets of those bad assets, and the government (FDIC) holds them and auctions them at appropriate times when those properties have a demand market for them and can be sold for more than the government paid the financial institutions under current market pricing.

Shareholders of those financial institutions are the big losers. But, if they don’t sell, but hold their shares, those institutions are back in the business of lending and borrowing and investing again with clean balance sheets and they are free to leverage their assets to grow their business under the new leveraging rules that will prevent this catastrophe from reoccurring until memory fades and America has to relearn its history by repeating its mistakes, yet again.

WW, the Glass Steagal Act effectively prevented the banks from incestuously engaging in all manner of other financial lines of businesses like insurance, investment trading, etc, insuring that a repeat of the bank failures in 1929 caused by the Wall St. crash, would be averted. It protected the banking system by insulating it from high risk taking, insuring America’s economic and monetary system rested upon sound banks regulated by sound accounting and oversight provisions.

The Gramm-Leach-Bliley Act through the doors open wide for mergers and acquisitions by banking institutions to engage in insurance, investment trading, and other forms of financial activities thus both creating enormous single entity financial institutions like AIG whose entangled transactions permeated the economy so deep and wide as to render it too large to allow to fail if it failed to remain solvent. It also permitted non-banking financial institutions to engage in banking lines of business for their other customers, further blurring the lines and effectively removing them from formal banking accounting practices enforcement and oversight.

Hence the leveraging of both banks (via credit default swaps and purchasing and selling of securitized assets for their balance sheets), and non-bank financial institutions without conformity to GAAP rules and banking industry oversight and inspections and enforcement, which allowed paper wealth transactions to be created greater than the total global economic product.

Banks made loans, then insured those loans, then sold those loans, and bought others, and invested proceeds from these transactions in hedge funds and other investments, making accounting practices virtually impossible to track, oversee, and enforce, especially under an administration which followed a laissez faire policy with financial institutions.

If I can give you a loan for a house, and sell insurance to protect the collateral value of that house, and then sell that mortgage to someone else, guess what happens? I continue to collect insurance premiums on a property I no longer monitor or have control over, and hence, I make profit whether that property devalues, ceases to exist, or the buyer defaults, because I have collected the insurance premiums on my loan all along without having to incur the expense of periodically assessing the current market value of that property nor the borrower’s changing actuarial risk status, (such as unemployment).

A very profitable scheme until the house of cards crashes and everyone tries to unwind all those swaps and purchases and collect on the mortgage insurance which was invested in other losing value properties, evaporating the reserves to cover the insured value of the mortgages.

It wouldn’t, couldn’t, have happened if Gramm-Leach-Bliley Act had not passed and been signed into law without safeguards by Pres. Clinton in 1999. The Glass-Steagal Act was specifically adopted to prevent the very scenario we are now experience, in many ways a direct repeat of the banking failures of 1930.

Those who reject the lessons of history are doomed to repeat it. The irony is, Phil Gramm was an economist, and damn well should have acknowledged the wisdom and benefit of the history of the Glass-Steagal Act, and no doubt did, but, his constituents and campaign contributions were coming from the financial industry which sought profits without government oversight or regulation. Leach followed Gramm’s lead like an ignorant fool. Bliley history I am not familiar with so I don’t know what his excuse was. Clinton damn well should have known better, but apparently didn’t.

I would like to know what the conversations were between Clinton and his economic advisers of the time. I suspect he was warned sternly about passing the GLB Act, and ignored those warnings in pursuit of his balanced budget agenda and endeavors to increase business tax revenues by promoting more financial business. That is speculation on my part however, as I have not read any historical account of Clinton’s role in signing that bill.

This is an excellent article. I had no clue
how some of these instruments worked. What I do know for a fact is that the American people have been taken for a sleigh ride of historic proportions. I do agree that the shadow banking system needs to go, and go right away. It is apparently a paper tiger and by doing as you suggest, going back to standard banking practice
is the way to go. One suggestion I have been making is that the “credit score system” needs to be scrapped. So many Americans are denied funds when they truly need them, because they are stuggling & juggling paying the bills. I suggest going back to the system of personal credibility, where if a person pays their bills and has worked hard, they should be extended credit for resonable items i.e. their car no longer works,
they need a new or newer one. A system in their home breaks i.e. sewage or well, heating. If they have had a problem in the past credit wise, then is there a legitimate reason for it.The funds need to get into the peoples hands. they will spend and the economy will right itself.

I don’t think most car companies fall into this category…they failed on their own. Most auto financing is done in-house, as Ford Motor Credit Company, GMAC, etc., or through Credit Unions. These entities carry the debt to termination, either when it is paid off or it defaults. Real Estate and Business loans are the ones that have floated into the stratosphere, and lost their value.

Our ‘big three’ lost their collective shirts by giving share holders all the breaks and not modernizing their plants and workforce (oh, and by giving great bonuses to the biggies who failed to do good business).

It’s weard the car commercials I see now. All the foreign cars are around the 10-16 thousand $ range but the US cars are around 33 thousand. I can buy my house for less than that. I don’t understand why they need to put all those fancy gadgets in a car either.

WW, great question! The answer however is no. GMAC for example ( the financing arm of General Motors ) was formed in 1919.

The Glass Steagal Act was aimed at banks, not internal financing actions of non-banks. However, if I recall correctly from an economics text, prior to the GLB Act, GMAC had to seek a Glass Steagal Act exemption in the 1980’s to enter the real estate mortgage market business, which came with strings attached. With the GLB Act in 1999, GMAC was permitted to throw those strings attached out the window.

And in 1999 GMAC was free to purchase a Bank of N.Y.’s asset-based lending and factoring business unit, creating an entirely new Commercial Finance Group for General Motors. By 2008, General Motors had grown into a financial institution so large and diverse as to be deemed “too large to allow to fail”, at tax payer expense. (Which is why GM’s Exec was so cavalier in heading to Wa. D.C. to ask for TARP or Bailout Funds).

For decades many Democrats and Republicans had hammered away at the Glass Steagal Act, claiming its constraints on American financial institution growth were unacceptable. (Despite repeated record-breaking profit growth throughout those decades.) The GLB Act became the fruit of Wall Street lobbyist’s hard work in the halls of Congress those many decades, and pitching the act to a President whose own economic agenda could benefit in the short term from the passage of the GLB act. (Stupid Clinton).

VOILA! Short term gains resulting in long term devastating consequences for the entire nation and world economically. This is the primary reason I have for objecting to legal term limits on Congress. History and its lessons must be preserved over the decades in the minds and considerations of our representatives, especially in our Senate. Many hate Sen. Robert Byrd, but, his institutional and American historical input on the Senate Floor has been vital on several occasions in preventing repeats of some of history’s recorded flawed policies or rationales for policy making.

Ironically, Sen. Byrd voted FOR repeal of the Glass Steagal Act to make way for the GLB Act.

More Democrats opposed repeal than Republicans. Only one Republican voted against repeal of Glass Steagal, Sen. Richard Shelby. One other Republican took no position either way, and that was John McCain, present but not voting.

Here’s how to understand present day economics. Find a big room. Fill it up with smoke and mirrors. Don’t forget to throw in a few panes of clear glass just to make it interesting. Add the “experts” to talk about it and call it the Sunday morning TV “information” shows. Examples; Meet The Press, Face The Nation, etc., etc.

Posted by: Stephen Hines at February 17, 2009 8:55 PM

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